Sources of Exchange Rate Fluctuations in Kenya: The Relative Importance of Real and Nominal Shocks

The purpose of this study is to determine the factors contributing to real exchange rate fluctuations in Kenya; whether the real exchange rate responds more to real or to nominal shocks. A vector autoregression framework is applied in the analysis yielding impulse responses and decompositions of the forecast error variance. The results demonstrate the important role played by real shocks in causing exchange rate fluctuations, in particular highlighting the predominant role played by demand shocks. It is also shown that shocks hitting the Kenyan economy are asymmetric to shocks affecting the US economy. Thus, the Kenyan economy is buffeted by idiosyncratic shocks which are more country specific. Consequently, it can be argued that the exchange rate plays an important role as a shocks absorber in the Kenyan context.